Life insurance companies that sell more of unit linked insurance policies (ULIPs) may soon have to infuse additional capital to meet solvency requirements.

The extent of infusion will become clear after the Insurance Regulatory and Development Authority (IRDA) comes out with a new national standard for valuation of insurance companies, with effect from March 31, 2010 (for 2009-10), redefining solvency requirements based on different risks such as exposure to the equity market, mortality experience, expenses incurred and lapses in premium payment by policyholders. ULIPs account for over 80 percent of the total portfolio of most life insurance companies in the country. In one private sector insurance company, the contribution of ULIPs to total premium collection is as high as 98 percent.

While the ULIP as a product is popular, it is highly exposed to market volatility.

“The existing definition of solvency margin is an over-simplified measure of a company's credibility,” R. Kannan, Member (Actuary), IRDA, said, pointing out that the new liability weighted solvency requirement might lead to additional capital infusion by companies having high exposure to different risks.

Solvency margin for an insurance company indicates its ability to pay claims and, at present, it is calculated as the ratio of capital available and what is required to remain solvent. In India, the solvency requirement for insurance companies is 150 percent.

The new solvency valuation will take into account the varying risks across different kinds of policies, rather than the average measurement of risk of a company, Kannan explained.

“The system paves the way for valuation of the insurance sector entirely by risk-based capital,” he said, adding that it might help reduce capital requirement for the companies while enabling them to write more new business at affordable premium.

The system, adopted in some developed countries, is in line with the Basel II norm for the banking sector. It would also be compliant with the proposed International Financial Reporting System, he added.

The new valuation, to be based on such parameters as Economic Capital (risk-based solvency requirement) and Market Consistent Embedded Value (the value of future streams of premium from existing business), would also help in fair determination of share prices of an insurance company during the launch of its IPO, Kannan said. “Companies exposed to higher degrees of risks will have larger capital requirements and, therefore, may clock lower profits. This will result in a lower share price of the company during IPO,” he said.

With the new valuation in place, prospective shareholders would have a fair idea about the company's ability to generate returns, while policyholders can better compare life insurers' ability to settle claims, Kannan added.